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# Calculating EBIT-EPS, capital structures, leverage

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1. Geoff's Golf Clubs is considering purchasing a small firm in the same line of business. The purchase would be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate how the two alternative financing plans will affect the earnings potential of the firm. Total financing required is \$4.5 million. The firm currently has \$20,000,000 of 12 percent bonds and 600,000 common shares outstanding. The firm can arrange financing of the \$4.5 million through a 14 percent bond issue or the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.

(a) What is the degree of financial leverage for each plan at \$7,000,000 of EBIT?

(b) What is the financial breakeven point for each plan?

2. Kiarra Doll Factory is considering two capital structures. Assume a 40 percent tax rate and expected EBIT of \$50,000.

Source of Capital Structure 1 Structure 2
Long-term debt \$500,000 @ 8% \$350,000 @ 7%
Common Stock 10,000 shares 20,000 shares

(a) Calculate two EBIT-EPS coordinates for each of the structures, using \$50,000 as one of your choices.

(b) Plot the two capital structures on a set of EBIT-EPS axes.

(c) Indicate over what EBIT range, if any, each structure is preferred.

(d) Discuss the leverage and risk aspects of each structure.

#### Solution Summary

This solution is comprised of detailed calculation and explanation to the following:

1. Geoff's Golf Clubs is considering purchasing a small firm in the same line of business. The purchase would be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate how the two alternative financing plans will affect the earnings potential of the firm. Total financing required is \$4.5 million. The firm currently has \$20,000,000 of 12 percent bonds and 600,000 common shares outstanding. The firm can arrange financing of the \$4.5 million through a 14 percent bond issue or the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.

(a) What is the degree of financial leverage for each plan at \$7,000,000 of EBIT?

(b) What is the financial breakeven point for each plan?

2. Kiarra Doll Factory is considering two capital structures. Assume a 40 percent tax rate and expected EBIT of \$50,000.

Source of Capital Structure 1 Structure 2
Long-term debt \$500,000 @ 8% \$350,000 @ 7%
Common Stock 10,000 shares 20,000 shares

(a) Calculate two EBIT-EPS coordinates for each of the structures, using \$50,000 as one of your choices.

(b) Plot the two capital structures on a set of EBIT-EPS axes.

(c) Indicate over what EBIT range, if any, each structure is preferred.

(d) Discuss the leverage and risk aspects of each structure.

\$2.19